The Internal Organization of the Firm and the Shape of Average Costs

Abstract

Do costs of coordination limit the size of firms? Do they lead to rising average costs at high output levels? A simple model of a firm which employs production and administrative labor, and where output is declining in coordination time by the latter, answers this question in two steps. First we derive a cost minimizing hierarchical structure for any given size of production labor. This structure shows similarity to that reported in the literature for both business and military organizations. Then we use the administrative technology that is developed to derive conditions under which average costs do eventually rise even in the presence of increasing returns to production labor. The presumption of a limit to the size of firms is shown to hold under reasonable, though not all, conditions